Banking is crazy [Matthew's Journal]

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British banks' capital (which regulators use in deciding how much they ought to be allowed to lend out) isn't money, but rather insurance! How on earth is that a sensible way for the economy to be run? I think we should be thinking very seriously about stiffer regulation of the financial sector.

In related news, since the Office of Fair Trading was making noises that maybe the result of a Lloyds / HBOS merger would be a bit of a monopoly, the government is to legislate to stop the OFT or Competition Commission from objecting. I'm sure that's...ethical.

As an aside,

pestons_picks makes interesting reading, and I'm not generally that interested in economics!

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There are 17 comments on this entry. (Reply.)

Is this worse than holding capital in the form of cash in a bank, which might then go bust?

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If I'm a bank, then I think it's worse for me to have my "capital" as insurance I bought against my loans to people going bad than as actual money in my vaults/whatever.

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Money in a bank's own vaults doesn't earn them any interest - would you insist that all capital was held in this form?

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It doesn't seem like capital if it isn't in a form like money or bullion, or fine art or something similar.

If I have some capital (i.e. money) and I give it to you in return for some nebulous concept like insurance or the promise of future payment, then I don't have my capital any longer, I have bought something with it.

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I'd say that a reliable promise of future payment can be a lot less risky than a commodity, a volatile luxury good, or quite a lot of world currencies. You're happy with Bank of England notes, right?

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Yes, I know what Bank of England notes have written on them, but while they do say promise to pay I'm classing them as money, just as much as florins and groats.

The promise to pay that I'm talking about is things like the futures market and other such nebulous things.

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No, I'm not saying that at all. The regulators, AIUI, require banks to have so much real capital depending on how many loans of what risk they have given out; the insurance-buying enabled them to claim they had more capital than they actually did, meaning they were more exposed to risk than they ought to have been.

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The insurance-buying allows them to say that the insured loans are less risky than they would otherwise be, and so need to be covered with less capital.

The problem is that the insurance-seller has sold insurance on events which are all happening at once, and so is forced to default causing vast cascading doom. This is about the only way for an insurance seller to explode, their business model being that ten million people pay them X a year to insure against uncorrelated annual events of probability 0.0002/year and cost 1000X.

Unfortunately, mortgage defaults aren't uncorrelated.

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Well, the point of the insurance was to relay the risk to the insurer. This works fine, until your insurer goes bust.

I think it's becoming obvious that the private sector can't meaningfully insure against systemic risk; that is always going to be dumped on the government. As a result the government should institute compulsory insurance premiums for finanacial institutions.

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That may be better than allowing the present situation to continue - but the insurance would just be used as a tax, and spent in the year it was paid, and no reserves would be available to deal with a systemic problem. (As an example, consider the reserves that National Insurance has not built up to pay pensions. Even civil service pension contributions are not, apparently, kept in a fund, but are spent on the basis that taxpayers in the future will pay for them.)

Then, at the time that everyone was getting poorer (except, maybe, state employees) taxes or government borrowing or both would rise to pay for the loan defaults.

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What would you do with the reserve?

HMG has basically the best credit in the world. There's no reason not to make use of it in exceptional situations.

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Nobody can meaningfully insure against systematic risk. It's contrary to the nature of insurance. The losses, by and large, have to lie where they fall. In some cases the state may intervene to protect innocent bystanders from the fall-out, but that's a matter of social policy. It functions significantly differently from an insurer.

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The proposed legislation to exclude the merger from OFT scrutiny reveals how important the large banks are to the government.

I've long wanted a return to tighter regulation; Simon Jenkins in The Guardian calls for bonuses in the financial sector to be made illegal as they artificially inflate turnover, which is surely worth considering.

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IMO, anyone who's been getting bonuses of £1m or more in the last 5 years should be forced to pay that back to the government to cover the costs of having to bail out any financial instution that's gone bust as a result of them being a greedy bastard.

The people I have sympathy with are the admin and support staff who are likely to be lose their jobs. And anyone who might lose their house and/or savings as a result of the current fiasco.

HBOS shares have been tanking over the last couple of days for no reason other than somebody somewhere is making speculative deals.

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anyone who's been getting bonuses of £1m or more in the last 5 years should be forced to pay that back to the government

Even if those bonuses were in company stock that is now (almost) worthless?

HBOS shares have been tanking over the last couple of days for no reason other than somebody somewhere is making speculative deals.

Not necessarily - the easiest way for a shareholder (eg an insurance company or pension scheme) to limit their exposure to the UK mortgage market is to sell shares in the UK's largest mortgage lender, ie HBOS.

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Actually, HBOS has a problem that the other big banks don't. It has a much higher ratio of lending to retail deposits than all of the other big UK banks. It therefore obtains money to lend on a larger part of its mortgages through the commercial market than any other UK bank (the previous recordholder in this regard being Northern Rock). When banks stop wanting to lend to each other, the cost of this commercial market borrowing (the interest rate on this is known as LIBOR) goes up, making companies who are more reliant on it less profitable.

If any big UK bank was at risk from the commercial lending market continuing to seize up (the issue which killed Northern Rock), it was HBOS. It was therefore the first to be the subject of short selling.

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Isn't the insurance-buying just borrowing someone else's capital? Say I had a billion pounds (wish that were true). I could do lots of things with it. I could lend it out, I could buy factories, I could buy cocoa futures, well, you get the idea.

One of the things I could do is I could use it to sell insurance to banks. If they give me shedloads of money, I will promise to give them the billion, should they need it.

In the meantime, I could keep the billion more-or-less liquid by lending it to someone trustworthy (tm) like the government. Or, to make it nicely circular, to the bank.

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Matthew's Journal

Banking is crazy

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October